Acquisition/Purchase of a Business

Back to: FINANCIAL ACCOUNTING SS2

 

Welcome to class! 

In today’s class, we will be talking about the acquisition/purchase of a business. Enjoy the class!

Acquisition/Purchase of Business

What is the Acquisition of Business?

Business Acquisition is the process of buying a company to build on the strengths or weaknesses of the company making the purchase. It can also be defined as a corporate action in which a company acquires ownership of another company by buying most, if not all of the other company’s ownership stakes. This thus enables the acquiring company to assume control of the newly-purchased company. An acquisition occurs when a buying company obtains more than 50% ownership in a target company. As part of the exchange, the acquiring company often purchases the target company’s stock and other assets, which allows the acquiring company to make decisions regarding the newly acquired assets without the approval of the target company’s shareholders. Acquisitions can be paid for in cash, in the acquiring company’s stock or a combination of both.

The process begins with defining the type of business that would make a good acquisition. Generally, businesses within the same segment or a highly complementary market segment are targeted. Once defined the target business is approached and if interest is shown due diligence is performed to ascertain the financial and other conditions of the business. When the financial terms are agreed upon, and the contract is signed the merger portion of the acquisition begins. Overlapping processes, personnel and products are evaluated and the better-performing pieces are retained.

Purchase Considerations during Acquisition

Each business acquisition comes with its own unique challenges, some very complex and others routine, involving business, legal and interpersonal relationship issues.  To have the greatest likelihood of handling these items properly, and of success in the purchase process and ownership of the business, it is in the best interest of the buyer(s) to dully take a lot of considerations into view by investigating the new business venture as well as consulting the services of professionals such as Lawyers, Accountants etc.  Below are some important considerations and steps a buyer should take in deciding to purchase a business.

1. Due Diligence: This is the legal term for carefully evaluating every aspect of the new business enterprise that is about to be acquired. A buyer should, therefore, hire the services of professional advisors whose function it will be to create a due diligence checklist and a list of questions and issues that need to be answered and resolved to the buyer’s satisfaction even as the buyer reviews and gains a better understanding of the business. Some example of questions to be answered include-
   • • What is the recent financial history of the business?
     • Any competition issues?
     • Is the price being paid for the business the “right” price?
     • Why is the business for sale?  Does any other party have a priority right to purchase it?
     • What are the cash flow, equipment, personnel and other needs of the business to operate successfully?
     • What is actually being purchased: inventory, equipment, raw materials, accounts receivable, contracts, a client list, a customer list, a lease?
     • What is the condition of the assets being purchased? etc.
2. Financing Considerations: If the purchase is to be financed, then the purchase contract must provide that the buyer has a reasonable opportunity to apply for and obtain a binding commitment for such financing.   The buyer must diligently pursue such financing as obtaining a loan commitment can take some time, and closing on the financing may be a challenging process to the buyer, especially if the financing is being provided through a special governmental program such as an SBA loan, such as the 7(a) or 504 loan programs.
3. Management of the Business: Before purchasing the business, the buyers should have a solid understanding of the choice of entity to operate the business, who will own such entity, who will run the day-to-day affairs of the business (e.g., the officers or managers), how the officers or managers will be compensated and incentivized, and how the owners will monitor the officers or managers.
4. Carefully set up the Buyer’s Acquisition Team: Buying a business involves many risks and, to be done most successfully, requires an experienced team of professionals and advisers to assist the buyer through the purchase process.  Each member of the buyer’s acquisition team should bring the right amount of skills, training and expertise to enable the buyer to properly work through the purchase process:  an attorney experienced in buying businesses to recognize the critical issues and risks and help the buyer navigate through them; a banker, investment banker or a business intermediary/broker to assist in obtaining acquisition financing and, if desired or needed, equity investment; and an experienced accountant to review the tax returns and financial statements of the business and work with the lender.

Goodwill

Goodwill can be defined as an asset, but it cannot be seen or touched, hence it is referred to as an intangible asset. It can also be defined as the excess of the purchases considerations over the total value of assets fewer liabilities. It arises as a result of connection, reputation, and efficiency of a business. It is not a tangible asset and cannot be realized until the business is sold.

Reasons for goodwill

1. For patent and copyright protection
2. The location of a business premise may also induce the purchaser to pay for goodwill.
3. Managerial skill: The effectiveness and efficiency of the management of a company can give them the necessary reputation,
4. Quality of goods: The quality, durability of the products of a company can bestow a good name on it.
5. Possession of partial monopoly: when a company is not faced with much competition in the market, then it can become a monopolist.

Goodwill Valuation

There is no actual method of valuing goodwill. Yet, the following methods can be used-

1. Number of years
2. Super profit
3. Number of times of the gross annual fee income
4. Excess of the value of a business over the realizable value.

Characteristics of Goodwill

1. The value is subjective
2. It cannot be sold separately apart from other assets of the business
3. It may fluctuate from day today

Reasons for Acquisition

Companies perform acquisitions for various reasons. They may be seeking to achieve economies of scale, greater market share, increased synergy, cost reductions, or new niche offerings. If they wish to expand their operations to another country, buying an existing company may be the only viable way to enter a foreign market or at least the easiest way: The purchased business will already have its own personnel (both labour and management), a brand name and other intangible assets, ensuring that the acquiring company will start with a good customer base.

Acquisitions are often made as part of a company’s growth strategy when it is more beneficial to take over an existing firm’s operations than it is to expand on its own. Large companies eventually find it difficult to keep growing without losing efficiency. Whether because the company is becoming too bureaucratic or it runs into physical or logistical resource constraints, eventually its marginal productivity peaks. To find higher growth and new profits, the large firm may look for promising young companies to acquire and incorporate into its revenue stream.

When an industry attracts too many competitor firms or when the supply from existing firms ramps up too much, companies may look to acquisitions as a way to reduce excess capacity, eliminate the competition, or focus on the most productive providers.

If a new technology emerges that could increase productivity, a company may decide that it is most cost-efficient to purchase a competitor that already has the technology. Research and development may be too difficult or take too much time, so the company offers to buy the existing assets of a company that has already gone through that process.

 Evaluation

1. What is business acquisition?
2. What are some reasons for business acquisition?
3. What are the methods for measuring goodwill valuation?
4. What is goodwill?
5. What are the factors to be taken into consideration when making a business acquisition?

 

In our next class, we will be talking about Purchase of a Business – Format preparation of New Business Account.  We hope you enjoyed the class.

Should you have any further question, feel free to ask in the comment section below and trust us to respond as soon as possible.

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